THE SECRET PM: COACH
Since 2009 rising corporate bond prices, driven in part by falling risk-free interest rates as well as shrinking default premiums, mean corporate cashflows have been discounted at lower and lower rates. In other words, corporate cashflows have been valued at higher and higher PE ratios. Any company that has demonstrated consistent earnings growth has seen its PE shoot higher, especially since 2011. The UK apparel retailer Next, for example, saw its PE ratio increase from roughly 10x to 20x.
Today’s high PE ratios are not evidence of a bubble or a reason for stocks to crash, rather these high PE ratios are a perfectly logical response to the change in discount rates. Corporate bond interest rates of 8% in 2009 were equivalent to a PE ratio of 12x, whereas corporate bond interest rates of 5% today are equivalent to a PE ratio of 20x. Just as today’s low corporate bond yields mean future returns from investing in corporate bonds will be low, the only thing today’s high stock PE ratios mean is that future returns from investing in stocks will be low.
As a stock investor high returns are no longer a matter of simply enjoying a rising tide of higher PE ratios: the UK’s FTSE is flat on the year, so too is the US’s Russell 2000. One way to get high returns going forward is to take on “uncertainty risk,” i.e., be willing to stomach bad news and invest in companies with uncertain future profit levels but where the value ascribed to the business today is very low.
A good example is US handbag maker Coach. Coach is a straightforward, profitable business that made a few big strategic errors in an effort to boost short term profits. Those errors wiped $9bn off the company’s market cap. Management have admitted fault. In June they made a 5 year plan public that seeks to “reset” the business by correcting their past mistakes. The plan ultimately targets sales of roughly $5bn and profits of $1bn by 2018. These targets are not outlandish – Coach reported sales of $5bn and profits of $1bn in 2012. With a market cap today of $9.6bn Coach clearly has tremendous potential to be a high return investment if management can achieve their plan.
Coach was spun out of Sara Lee and listed in 2000. It’s main strategy was making luxury “affordable” with average handbag price points between $200-300 – at least 50% cheaper than traditional European luxury labels, like Vuitton or Gucci. For most of the 2000s Coach had no strong direct competitors at the “affordable” luxury price point, allowing the company to grow unimpeded to about a 30% share of US handbags. Sales grew from $600mln in 2000 to over $3bn in 2007. The driver of this growth was “own-store” openings: total selling square footage increased at a 20% compound rate over those 7 years, which paced the 27% growth in sales.
Without strong competitors Coach was didn’t bother to reinvest heavily into its stores, its product or its marketing. Product design and marketing spend ran at less than 5% of sales, about half the amount spent by other branded goods companies. Little reinvestment in the brand allowed Coach to report 38% operating margins in 2006. Looking at other accessory-apparel companies it is clear that Coach was “over-earning” during 2005-2007 by milking the brand and underinvesting in its stores and image. For example, best-in-class luxury apparel business like Hermes and Gucci reported operating margins of “only” 32-33%, while more “accessible” price point apparel companies like Ralph Lauren have margins way down at 15%. Looking at it another way, during 2006 Coach had store, product and marketing costs of less than $2mln per store, whereas Burberry is spending about $3mln per store.
When the recession hit in 2008 sales growth slowed dramatically. US comparable store sales retreated 7% resulting in a big deleverage of costs and ultimately a 15% decline in operating profit. Without true competition Coach’s management didn’t realise the damage being done by underinvesting in the brand, so they compounded that mistake during the recession: in response to consumers’ reluctance to spend at full-price stores management decided to ramp up the “off-price” outlet business and increase promotions in that channel. Between 2008 and 2013 the number of outlet stores doubled: from 111 to 207 while the number of full-price stores remained stable. During the recession Coach was adding 10-12% of new selling space per year almost all in the outlet channel. This kept sales growth up: sales grew 12% in 2009 and 15% in 2010 and 2011. Between 2008 and 2012 US sales increased from $2.3bn to $3.5bn, but most of this $1bn in new sales was promotion-driven from the outlet channel. Coach had become a junkie for low-quality sales growth and had little interest in investing back into the brand, and without competitors the strategy kept delivering profit growth.
The shift in channel mix to off-price stores pushed gross margins lower, and, the growing but less profitable Chinese business put upward pressure on operating costs. Altogether the double digit sales growth sourced from the US outlet channel was not resulting in any cost leverage: operating margins actually fell from 32% in a 2009 to 30% in 2012. This left management between a rock and a hard place. They could deliver growth but only by hurting the company’s profit metrics, which meant the revenue growth brought no scope for increased investment in the brand. Instead of accepting that the economic environment dictated a period of low or no growth and that the long-term health of the business would be best served by increased brand investment the management continued to compensate for the lower gross margins by limiting product and advertising investment to around 5% of sales. For context, Prada, for example, spends closer to 8% of sales of product design and advertising.
Coach management’s strategy finally came unstuck in 2013 with the emergence of a true, strong competitor in the affordable luxury category, namely Michael Kors. All of a sudden shoppers in Coach’s neglected mainline stores had a viable alternative. The result was a major drop off in Coach’s sales as customers flocked to Kors. In Q2 to end December 2013 Coach’s US comparable store sales fell 14%, while Kors US comparable store sales increased 24%. In Q3 Coach’s US sales were down 21% versus Kors up 30%. Coach’s market cap roughly halved from $18bn to $9bn in response. By the June 2014 investor day management surrendered: admitting to underinvesting in the brand. They announced a 5 year strategy reset.
The three central tenets of the new strategy are store rationalisation, renewed brand and product investment, and reduced promotions. Specifically, 70 of its 330 full-price US stores will be closed and $570mln will be spent rejuvenating the remaining stores, and, the number of outlet stores will be held stable. Investment behind the product design and the brand will be increased to over 6% of sales from 5% currently. Finally promotional events in the outlet channel will be reduced from weekly to monthly frequency. Taken together the new strategy aims to build a sustainable sales base by investing in the store experience, the product design, and the brand, instead of going for “easy” sales growth through high-frequency promotional events in the outlet channel.
The store closings and reduced promotions will clearly hurt sales. US sales fell 19% in the most recent quarter and are expected to be down around 25% for the year. Coach is essentially cutting its losses and rebasing US sales to around $2.3bn, the level achieved prior to the big ramp up of the outlet business. Lower sales will mean cost deleverage. This coupled with increased investment in stores, product design and marketing will result in operating margins falling to around 17-18% this year. Operating margins were 21% in Q1, for example. Once the store base reduction is complete and costs are realigned management expects operating margins between 20% to 25%.
So looking forward, in three years time with its store rationalisation and investment behind it Coach will have around $2.5bn of rebased US sales and $2bn of international sales. Enough to achieve $850-1,150mln in operating profit, which equates to around $600-760mln of net profit, all of which will be free to distribute to shareholders as Coach carries no debt and the major store capex will be complete. On today’s market cap of $9.6bn that’s a yield of over 7%. The stock would need to rally 50% just to match the broad market’s yield. Lookin five years forward management hope to have operating margins back at 30%, which would be good for $1bn in net profit and a distributable yield of over 10%. Clearly if 25%-plus operating margins are credible then Coach has all the ingredients of a high return investment.
Are 25% operating margins possible? The key reason Coach is such a profitable business even in the face of huge sales shrinkage is its industry price positioning, which allows it to earn very high gross margins and at the same time sell from cheaper locations. European luxury goods makers sell handbags from $1,500 upwards. Those high prices set a category benchmark for branded luxury handbags and give Coach (provided it retains some brand value) a lot of opportunity to sell bags for very high gross margins (70% plus) in the $400-$600 price bracket. Moreover, by selling branded bags 60-80% cheaper than European companies Coach can get away with selling from lower cost locations like malls since the customer simply doesn’t demand the same level of service and exclusivity given the prices. This allows Coach to “save” about 5% of sales on lower store costs. The European luxury goods companies rely on exclusivity and so the pricing “umbrella” for Coach is likely to persist. Thus despite the big brand reset, which will see Coach “lose” nearly $1bn in sales, gross profit margins are likely to stay around 70%. For example, in the most recent quarter Coach reported 69% gross margins despite a 24% fall in US comparable sales.
So all that is left to do is to determine how much Coach needs to spend, on a consistent basis, to keep the product and stores fresh and the brand healthy. Thanks to its lower costs locations Coach has spent historically 28-32% of sales on selling expenses which is roughly 5% less than a peer like Prada which has spent 31-34%. Administrative expenses around 5% of sales are equivalent for both Coach and Prada. There has been a persistent difference of around 3% of sales on product design and marketing spending, where Coach consistently underspent peers, at 4-5% of sales versus say Prada at 8%. If we assume Coach’s renewed store investment, and focus on flagship stores, pushes up selling expenses to 35% of sales (higher even than Prada), and marketing costs rise materially to 7.5% of sales (20% higher than management’s estimates) then total operating costs are likely to plateau around 47.5% of sales, a level roughly consistent with Prada and Burberry – both of which are spending heavily on brand investment and expensively located flagship store expansions.
A 70% gross margin less 47.5% operating costs comes out at 22.5% operating margins – right in the middle of management’s guidance for the next few years. With 22.5% margins Coach delivering $700mln of net income in three years is absolutely doable even with all the added investment spending. The focus on flagship stores means selling expenses are likely to stay elevated versus history, perhaps similar to Prada in the 32-33% of sales range. Even with persistently higher selling costs operating margins have a realistic chance of getting to the 26-29% range, close to management’s target of 30% by 2018. $1bn in net profit is therefore absolutely possible.
While the outcome of Coach’s dramatic resizing and brand reinvestment is uncertain by looking at its peers it is evident that Coach can deliver at least 22.5% operating margins, or at least $700mln of profit, over the next few years even while investing aggressively. If you can handle reports of falling sales and the uncertainty of the brand reinvestment at today’s market value of $9.6bn $700mln of net profit is a 7% distributable yield (around half of which will be paid out as a dividend). With each quarterly report the market is likely to gain more confidence that even as sales rebase much lower operating margins will nonetheless stabilise around management’s short-term target of 20-25%, allowing the stock to rerate. Moreover, if the brand reinvestment is a success and US sales start to grow the $1bn of net profit will be on the cards, which would mean the stock could easily double.
Today uncertainty is the source of high returns.